The Digital Euro and the Role of DLT for Central Bank Digital Currencies
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MAY 2020
FSBC Working Paper
The Digital Euro and the Role of DLT
for Central Bank Digital Currencies
Manuel Klein, Jonas Gross, Philipp Sandner
Digitization has reached the monetary system. The advent of
crypto assets, such as Bitcoin and Ether, revealed numerous
advantages these digital assets based on distributed ledger
technologies (DLTs) can bring: Using DLT can enhance the
security of sensitive financial transaction data, increase
transaction speed through faster processing and settlement and
automate numerous business processes through smart contracts.
These advantages ought to be realized in the conventional
monetary system as well — not only in the "crypto industry”. DLT
can be used both to digitally represent bank deposits and to
tokenize central bank money via central bank digital currencies
(CBDCs). Current DLT-based CBDC projects and prototypes
among others by the Chinese and Swedish central banks, but also
initiatives by the European Central Bank (ECB), show that DLT
will be an essential pillar of the digitization of the monetary system
in particular and the financial system in general in the future.
Frankfurt School Blockchain Center
Introduction1
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contact@fs-blockchain.de
The emergence of digital crypto assets, such as Bitcoin in 2008, and the
underlying distributed ledger technology (DLT) have led central banks
Follow us
www.twitter.com/fsblockchain around the world to think intensively about the digitization of the monetary
www.facebook.de/fsblockchain system and the introduction of central bank digital currencies (CBDCs). The
Bank of England pioneered this movement and started to analyze the
Frankfurt School of
introduction of its own CBDC already in 2014. Over the last years, the topic
Finance & Management gGmbH
Adickesallee 32-34 has reached global scale — at the latest with the announcement by Facebook
60322 Frankfurt am Main
Germany
1
in the summer of 2019 to launch a digital DLT-based, global crypto asset
"Libra" that will be backed by several fiat currencies and government bonds.
An in January 2020 published study by the Bank for International
Settlements (BIS) shows that 70% of all global central banks are currently
analyzing the issuance of their own digital central bank currency (see Boar,
Holden, and Wadsworth, 2020). 10% of the participating central banks said
that they are likely to introduce such digital currency in the short-run (up to
three years) and 20% in the medium-term (up to six years) (see Figure 1).
Further, 15% of central banks consider the introduction of a CBDC possible
in the next three years (an additional 18% in the next six years). The direction
is clear: more and more central banks are researching CBDCs and are
planning to introduce own digital currencies in the upcoming years. It is,
therefore, only a matter of time before the first CBDCs will be introduced.
Figure 1
Likelihood of CBDC introduction according to central banks
Source: Boar, Holden, and Wadsworth (2020).
In the public debate, DLTs, e.g., blockchain technology as a subcategory of
DLTs, are often assumed to be the technological basis for the digitization of
the monetary system and the introduction of a CBDC. This technological
choice is not necessarily obligatory. However, the discussion is mainly driven
by the emergence of this new technology and the new technological features
it entails. Since there are different possibilities for introducing a CBDC old
economic ideas about the design of the monetary system are brought back to
2
the center of the scientific debate.2 DLT enables us to rethink all the different
types of money in today's monetary system and to materialize the advantages
of DLTs in different ways. One strong argument in favor of using DLT is that
delivery and payments of assets can be organized on integrated platforms. A
DLT makes this possible and would enable real-time settlement, e.g., in the
settlement of financial securities.
In order to put the current developments into perspective, this article first
explains the existing monetary system and discusses the forms and
advantages of a DLT-based digital Euro. The focus will then be put on
showing the possibilities to digitize the different types of money and,
especially, on CBDCs. We analyze current CBDC projects and explain the
intentions behind the respective CBDC introduction. In addition, possible
threats for the financial system caused by a CBDC introduction, such as
financial stability and data protection concerns, are discussed, and possible
solutions are outlined.
The current monetary system
The anchor of the current monetary system is physical cash. Cash is the only
legal tender and can solely be printed by central banks. Since the abolition of
the gold standard in the early 1970s, cash is no longer backed by gold but is
generated by central banks through lending activities or by purchasing assets
such as government bonds. The term fiat money — derived from the Latin
phrase for "Let there be money" — thus accurately describes that cash can be
created at will by central banks. However, central banks issue cash not
proactively but reactively in response to the expansion of commercial bank
money and driven by the demand of bank clients.
Physical cash represents only a small fraction of the money supply in the
existing monetary system. The vast majority of the money supply in
circulation — around 87% of the Euro area money supply, according to the
Statistical Data Warehouse of the European Central Bank (ECB) — is
commercial bank money, which is used for payments, e.g., via debit or credit
cards. Commercial bank money is recorded in the current accounts of citizens
at the respective banks. Bank money is created whenever banks grant loans
or purchase assets such as shares, bonds, etc. (see Deutsche Bundesbank,
32017). Commercial banks do not require central bank money or savings
deposits before lending, as the theory of the money creation multiplier or the
bank intermediation theory suggests. Instead, the necessary liquidity is
obtained retrospectively on the money markets or from the central bank (see
McLeay, Radia, and Thomas, 2014). In the existing monetary system, the
proactive generation of money is thus the responsibility of commercial banks.
Another form of central bank money, the so-called central bank reserves, is
used to transfer liquidity between banks. In most countries, only banks and a
few selected (financial) institutions have access to central bank reserves and,
thus, to the central bank's balance sheet. Central banks (usually) only react
reactively and as a response to banks' creation of bank deposits by increasing
cash and central bank reserves (see ECB, 2012). Since the 2007/2008
financial crisis, however, central banks have increasingly abandoned a purely
reactive approach: In the context of unconventional monetary policy
measures such as quantitative easing, central banks have proactively
generated central bank reserves on a large scale through extensive asset
purchase programs.
The three existing types of money can be distinguished as follows:
• Cash is the only legal tender and is issued by the central bank. It is
peer-to-peer transferable, i.e., without an intermediary, it is not
digital and is accessible to the general public. In contrast to the two
other types of money, cash allows anonymous transactions. Cash
does not bear interest, which means that cash creates an effective
lower bound for monetary policy. Since bank money can be
exchanged for cash, rational bank customers would exchange their
bank deposits into cash if the interest rates on bank accounts
became (strongly) negative. Cash is generated reactively by the
central bank, and the quantity is based on the cash demanded by
banks and ultimately by their customers.
• Bank money is issued proactively by commercial banks and
represents a claim on the commercial bank for the payout of cash.
The account balance of a bank client indicates that cash in the
amount shown can be withdrawn by the client from the respective
bank account. According to the ECB, however, the Euro area's bank
4money is only covered by around 13% of cash. The remaining assets
are claims on borrowers and other assets the bank holds. This
makes holding bank money risky: bank customers are exposed to
liquidity risks, creditor risks, and market risks. Nevertheless, bank
money is tied 1:1 to the value of cash and reserves and can be
withdrawn at the same nominal value as cash. The interest rate on
bank deposits is set by the individual bank but other interest rates,
such as interest paid on bonds, interbank rates, and ultimately the
refinancing rate of central bank reserves represent upper bounds.
• Central bank reserves are issued by the central bank but are not
available to the general public. Since reserves are a form of central
bank money, the holder of the reserves is not exposed to liquidity or
creditor risk, as it is the case with bank money. By definition, central
banks, unlike private banks, cannot go bankrupt because they are
the only institutions that generate legal tender and could, in theory,
even operate with negative equity (see Bunea et al., 2016). Central
bank reserves — like cash — are, therefore, a risk-free form of
money. However, unlike cash, they are transferable digitally.
Reserves are interest-bearing and are remunerated at the central
bank deposit rate.
If trust in the banking sector – and, therefore, in the money issued by banks
— declines, so-called bank runs can emerge. In case of a bank run, bank
customers withdraw their money from their checking accounts and convert it
into cash in large quantities. Such bank runs can lead to massive liquidity
shortages for banks, as banks have to convert large amounts of their digital
reserves into cash. Depending on the extent and duration of the bank run,
banks are dependent on emergency loans from the central bank to meet the
demand for cash when they cannot sell other assets to generate more
liquidity.
The example of Cyprus shows that bank runs are not only a theoretical
construct, but that mistrust in the banking system can indeed not be ruled
out. In 2013, bank customers feared that their deposits would no longer be
safe and withdrew more than 40% of their funds within one year. In the
5financial crisis of 2007/2008, bank runs also affected many banks in the Euro
area — e.g., Northern Rock in Ireland.
After discussing the existing monetary system, we now address the
digitization of fiat currencies — in the case of the Euro area, the Euro. The
debate on the digitization of the monetary system includes, above all, the
discussion of whether distributed ledger technologies (DLTs), such as
blockchain technology, could or should be used for issuing digital money.
Advantages of a blockchain-based Euro
The issuance of a digital Euro via a DLT system could bring considerable
advantages:
1. Security: In the current financial system, data is typically stored
centrally on the servers of a third party, for example, the servers of a
(central) bank. By using DLT, however, transaction data is stored
simultaneously on a large number of computers. Decentralized
storage of data would make the system more resistant to hacker
attacks, as there would no longer be a single point of failure.
2. Resistance to manipulation: Since transactions are stored on
several computers simultaneously, it is not possible to manipulate
or subsequently change transaction data. Such resistance to
manipulation offers considerable advantages, especially in
applications where all participants must have the same level of
knowledge, but do not necessarily know and trust each other.
3. Automation and programmability of money: Technological
innovations such as smart contracts and peer-to-peer (micro)
payments, e.g., between machines, can be realized in Euros and
would not have to be processed in volatile and/or unregulated
crypto assets. Smart contracts would enable internet of Things (IoT)
devices connected to the DLT, such as machines, cars, and sensors,
to offer services on a pay-per-use basis. A DLT-based payment
system is, therefore, particularly promising in the context of the
machine economy. IoT Analytics estimates that by 2025 more than
20 billion devices will be connected to the internet — three times as
6many devices as there are people on earth today (see IoT Analytics,
2018). Many of these devices will also be integrated into a payment
network so that in a few years, this network will comprise hundreds
of millions of devices. DLT is best suited for equipping millions of
devices with a computer chip and, thus, also with their own digital
wallet. Devices could transfer digital Euros directly from wallet to
wallet, and a device would be able to receive payments and transfer
money autonomously.
4. Efficiency gains: Furthermore, in the case of a peer-to-peer DLT
Euro system, significant efficiency gains could be achieved. The
payment system could be greatly simplified, and many
intermediaries would no longer be needed (e.g., clearinghouses).
This would significantly reduce the costs of the payment system and
process transactions faster. Significant efficiency gains would be the
result, especially for cross-border payments. Nowadays,
international transfers from Germany to Argentina, for example,
take up to ten days and often cost up to 10% of the transfer amount
in fees. The use of DLT systems could enable immediate settlement
at very low transaction costs even between different currency areas.
A DLT system designed for central banks would have a different structure
than most existing DLT networks, such as the Bitcoin network. Since the
central bank inherits a high level of trust, it does not need to use a fully
decentralized DLT system that operates completely without mutual trust, and
through a distributed consensus mechanism.3
The Bitcoin network, through its "proof-of-work" consensus mechanism, has
managed to create a global, decentralized consensus on the conducted
transactions. The proof-of-work consensus mechanism requires network
participants to solve a cryptographic puzzle. The first party to correctly solve
the puzzle is rewarded with a certain amount of Bitcoins from the network
and acquires the right to confirm the last “block” of transactions. As a
consequence, network participants do not have to rely on third parties such
as (central) banks in the current financial system that decide over the validity
of the conducted transactions. However, this proof-of-work consensus
mechanism, which is the most secure and widespread mechanism to date, is
energy-intensive and leads to a low transaction throughput in the Bitcoin
7network. Currently, only seven Bitcoin transactions per second are technically
feasible. Other crypto assets use alternative consensus mechanisms such as
"proof-of-stake" or "proof-of-authority" to overcome the scaling issues of the
Bitcoin protocol. However, none of the mechanisms has so far proven to be
as secure as proof of work.
In contrast to the Bitcoin network, a central bank DLT system could consist
of a large number of identified and accountable network nodes that, in line
with certain rules, establish consensus on the transactions that occur (see
Danezis and Meiklejohn, 2016). Blockchain-providers such as Hyperledger or
Corda by R3, which partner with central banks around the world to test CBDC
prototypes, also use these “permissioned” blockchains that have known and
trusted validators. Such systems do not correspond to the vision and concepts
of the supporters of "crypto currencies", who propagate an open monetary
system that is not based on trust in third parties such as banks, the central
bank, or the state. However, numerous disadvantages of "crypto currencies",
such as the enormous energy consumption, the scaling issues, and the strong
price fluctuations, would be overcome, and the advantages of DLT would be
applied in the form of a stable and reliable digital currency.
The following section outlines possible ways how DLT can contribute to the
digitization of the monetary system and how the private sector could issue a
digital and “programmable” Euro.
Euro-backed stablecoins
The first possibility to use DLT to transfer Euros is to tokenize fiat money
deposited at banks, e-money providers, or other financial institutions to
create “stablecoins”. DLTs use so-called tokens to transfer values from A to B.
Each of these stablecoin tokens must be backed by respective units of money
(or other assets) deposited in the account of the client. The tokens must be
fully backed by deposits, which stabilize the value of these stablecoins stable
against a fiat currency such as the Euro. Holders of stablecoins must trust the
issuers of the tokens that all tokens are fully backed by deposits and that they
could be withdrawn even in case of 100% liquidation (see Sodhi, 2018).
8Stablecoin projects already exist for several years. The most prominent (fiat-
backed) stablecoin projects are Tether, TrueUSD, USDCoin, and Stasis. The
projects are relatively successful in maintaining a 1:1 peg to the underlying
fiat currencies. The exchange rates fluctuate only slightly around the unit of
account of the fiat currency, also due to arbitrageurs that use price
differentiations to yield profits.
Today, however, stablecoins are primarily used in crypto markets as vehicle
currencies for the purchase or sale of other crypto assets such as Bitcoin or
Ether and only rarely in "non-crypto-markets". This is mainly due to the fact
that stablecoins have so far not been regulated and are not covered by
statutory deposit insurance schemes. In concrete terms, this means that
although stablecoins are linked to existing currencies, they are not used as
means of payment due to a high degree of regulatory uncertainty. Customers
are exposed to issuer and liquidity risks, for example, if a stablecoin could not
maintain the peg anymore. Furthermore, many stablecoins do not have a
payout guarantee on the underlying deposits. Since 2019, however, first
companies have been using an e-money license to issue a fiat-backed
regulated stablecoin, thereby aiming to bring the "blockchain Euro" into the
real economy. These players include the German start-up Cash-on-Ledger
and the Icelandic start-up Monerium.
To date, the most popular stablecoin project is certainly the Libra project,
which the Libra Association around the Facebook subsidiary Calibra
announced in June 2019 and which has been updated in April 2020 (see
Gross, Herz, and Schiller 2019). The original plan of Libra was to issue a
multi-currency stablecoin (“Libra Coin”) only which is backed by a basket of
currencies consisting of not only bank deposits denominated in various fiat
currencies but also short-term government bonds. As a result of intensive
discussions with regulators and governments, Libra released an updated
concept in April 2020, stressing that, apart from the Libra Coin that is backed
by multiple currencies, also single-currency stablecoins, e.g., a Libra Euro,
will be issued. These national stablecoins will be backed approximately 20%
by bank deposits nominated in Euro, U.S. Dollar, Japanese Yen, etc. and 80%
by government bonds of the respective government or currency union
member countries. Even though the Libra tokens are not fully backed by bank
deposits but also by government bonds, which entail market risk, Libra
expects the coins to be stable against the tokenized currency. The Libra
9project shows how easily such stablecoins can be created and stresses the
advantages of using DLT for money payments. Therefore, the Libra project is
widely perceived as a "game-changer".
Given the two-tier structure of the existing monetary system, fiat-backed
stablecoins on DLT can be either backed by commercial bank money or by
central bank money. For the end consumer, this distinction seems not to be
essential at first sight as both types of money are denominated in Euro.
Furthermore, bank money is secured by deposit guarantee schemes and
therefore perceived as secure as central bank money. In times of banking
crises, however, this can make a significant difference: Bank deposits in the
Euro area are only secured by the deposit guarantee schemes up to 100,000
Euros and, as described above, only a fraction of bank deposits are backed by
central bank money.
Alternatively, stablecoin projects could also keep customers' deposits in an
account with an intermediary or trustee, which in turn is 100% backed by
central bank money. This is possible if the cooperating bank or payment
service provider backs the account balances of the customers of the stablecoin
project 100 % with reserves. This variant would correspond to a deposit with
the central bank secured by intermediaries or trustees, which can also be
transferred via a DLT system. This type of stablecoin, therefore, indirectly
accesses central bank money and is called synthetic CBDC (sCBDC) (see
Adrian and Mancini-Griffoli, 2019). One difference between an sCBDC and a
direct CBDC is that in the case of an sCBDC an issuer and credit risk exists,
whereas a direct CBDC bears no issuer, credit, or liquidity risk.
Central bank digital currencies (CBDCs)
Driven by the developments around crypto assets and the announcement of
the Libra project, a large number of central banks announced that they will
take an even closer look at the possibilities of the application of DLT and
therefore analyze the issuance of an own digital currency. Central banks
could, therefore, also be the issuer of programmable, DLT-based money (see
Figure 2, left-hand side).
10Figure 2
Taxonomy of programmable money
Source: Own illustration.
There are two ways of issuing central bank digital currencies (CBDCs):
wholesale and retail CBDC.
1. Wholesale CBDC: Central banks could change the interbank
payment system from a central clearing system to a peer-to-peer
system, leading to central bank reserves on a DLT. These digital
tokens would only be used for interbank payments, could only be held
by eligible financial institutions, and could not be used as a general
means of payment. Introducing a wholesale CBDC is suspected to
increase efficiency in the interbank market.
2. Retail CBDC: Central banks could also issue a new digital means of
payment to the general public, which would coexist with bank money
and cash and could be used as a general means of payment. Unlike
bank deposits, it would not be a claim on a legal tender but would
become legal tender itself, like cash. A retail CBDC could be designed
both interest-bearing or non-interest-bearing. The challenges of an
interest-bearing CBDC for monetary policy are currently intensively
researched in the academic literature and go beyond the scope of this
paper. The ultimate goal of a retail CBDC is to digitize physical cash
11and, therefore, preserve access to the central bank balance sheet for
non-banks in the digital age.
A wholesale CBDC would not fundamentally change the existing monetary
system: Non-banks would continue to keep their accounts with commercial
banks, and payments between customers of two different banks would
continue to be made using digital central bank money — however, using DLT-
based reserves. Banks would continue to create the vast majority of the money
supply, and central banks would continue to have access to the non-banking
sector only through physical cash. However, access to the payment system
could be widened to other financial market participants easily. This could lead
to further competition in the payment sector and disrupt traditional
correspondent banking where smaller banks hold accounts at larger banks
that manage the interbank payments in reserves for them. In addition to the
development around wholesale CBDCs of central banks, there are also private
sector projects such as Ripple or the planned JPM Coin project. Previous tests
and prototypes of wholesale CBDC projects, for example, in Thailand and
South Africa, have shown that DLT systems can increase transaction speed
through fast settlement in the interbank market. The use of DLT systems is
particularly advantageous if further transactions such as security transfers
would also be processed via a DLT-based transaction system (see Chapman
et al., 2017).4
A retail CBDC would make the Euro accessible to the general public as a
digital currency unit and, therefore, an alternative to bank money. This could
lead to significant changes in the existing monetary system as this digital form
of money would be issued directly from the central bank. The holders of retail
CBDCs would not be exposed to liquidity or creditor risk, as in the case of
bank deposits. Thus, a retail CBDC is, like cash, a risk-free means of payment,
but in a digital form.
The previously mentioned study by the BIS (Boar, Holden, Wadsworth, 2020)
shows that central banks are currently primarily researching retail CBDCs.
Central banks' motives for introducing retail CBDCs are manifold (see Figure
3). The study shows that the motives differ between industrialized countries
on the one hand and emerging and developing countries on the other:
Industrialized countries hope to strengthen financial stability, increase the
efficiency of payment transactions, i.e., by reducing transaction time and
12costs, and increase the security of digital transactions. Monetary policy and
financial inclusion considerations only play a minor role for central banks in
industrialized countries.
Figure 3
Motives for introducing retail CBDCs
Source: Boar, Holden, and Wadsworth (2020).
Developing countries, on the other hand, aim to improve financial stability,
the efficiency, and security of transactions, but above all, to reach a higher
degree of financial inclusion. Financial inclusion motives have, e.g., driven
the CBDC efforts in the Marshall Islands and other island groups, such as the
Bahamas or Barbados. In these nations, like in many third world countries
and developing countries, a large share of citizens is currently excluded from
the financial system since they do not have bank accounts.
Financial stability concerns
Central bankers and economists are currently debating how such a retail
CBDC system should be designed to preserve the stability of the existing
monetary system. Many economists, such as the president of the German
Bundesbank Jens Weidmann, see the main threat of a retail CBDC
introduction in the facilitation of "digital bank runs" — numerous customers
could exchange their bank deposits for the new digital central bank money
13easily (see Handelsblatt, 2020). In the case of such a digital bank run, banks'
liquidity holdings could be put under immense pressure and, in the worst
case, lead to bank illiquidity. In addition, the direct exchange of bank money
into CBDC could limit the ability of banks to create money by lending
activities, as banks would have to reckon with an outflow of funds into the
riskless CBDC at any time and thus would have to back the customers'
deposits with a higher percentage of reserves.
Banks engage in maturity transformation and finance long-term loans
through short-term deposits. The introduction of a digital form of central
bank money for the non-banking sector could thus trigger risks for maturity
transformation through potential and sudden withdrawal of liquidity. The
process of massive outflows of reserves from the banking sector is referred to
as "disintermediation" of the banking sector. An extreme scenario of this
disintermediation would be that banks could become pure intermediaries and
could no longer create money by granting loans. In order to provide the
economy with sufficient liquidity, the central bank itself might have to
generate CBDC units actively. A 2019 published study by the International
Monetary Fund (IMF) discusses money creation in a retail CBDC system and
sheds light on the active creation of CBDC units through lending (see Gross
and Siebenbrunner, 2019). Lending could still be carried out by banks, but no
additional bank deposits would be created in the lending process, as the loan
would have to be refinanced 100% in CBDC.
In fact, CBDCs can enable central banks to regain control over money creation
and to be the sole issuer of money, like the Chicago Plan in the 1930s had
foreseen (see Fisher, 1936). For years, economists, NGOs, and political
parties campaigned for a modern version of Irving Fishers’ “100% Money”
called “Sovereign Money”. Proponents of this structure of the monetary
system contemplate to create money when the real economy needs additional
money to grow — either via transfers from the central bank to parliament or
via a citizen's dividend (see Huber, 2017). DLT could facilitate this idea by
tying money creation to the development of the real economy via smart
contracts that automatically create new money when certain conditions are
met (see Rashkin and Yermack, 2016). The former Chief Economist of
Deutsche Bank, Thomas Mayer, even believes that the introduction of such a
100%-CBDC system would provide a chance to restart the Euro as a more
stable and future-oriented currency (see Mayer, 2019). Among others, the
14former Governor of the Spanish central bank, Miguel Ángel Fernández
Ordóñez, believes that this transition could lead to a far more stable banking
and financial system. He argues that such a system could provide the
reasoning for liberalization of the banking sector, which would foster
competition between banks and Fintechs in the market for loans (see
Ordóñez, 2020).
So far, three different approaches have been developed to prevent a digital
bank run and the disintermediation of the banking sector. Economists from
the Bank of England propose a parallel payment system, which would make
it impossible to directly exchange and "digitally withdraw" bank money into
CBDC. Consequently, bank deposits would not be directly convertible into
CBDC. Central banks would actively generate new CBDC units by buying
securities and, in return, create CBDC in the accounts of the sellers, both
banks and the general public. In secondary markets, the exchange of CBDC
and bank money between buyers and sellers could be enabled. This would
leave the stock of bank money in the system unaffected and thus prevent
disintermediation of banks (see Kumhof and Noone, 2018).
An ECB publication from January 2020 proposes a two-tiered CBDC system
with two different interest rates on CBDC balances (see Bindseil, 2020). This
two-tiered interest rate structure is expected to prevent bank
disintermediation — even if direct convertibility between bank money and
CBDC is given. If a certain CBDC threshold is exceeded in the central bank
account, the excess CBDC amount would bear zero or negative interest rates,
making it unattractive to hold CBDCs in large quantities and to use CBDCs as
a store of value.
The idea of a two-tiered CBDC interest rate on central bank balances is not
new: Currently, an amount of six times the minimum reserve that commercial
banks must hold with the central bank as a minimum liquidity requirement
is excluded from the negative deposit rate (see Deutsche Bundesbank, 2020).
In the Euro area, the minimum reserve currently amounts to 1% of bank
deposits. Currently, the deposit rate of -0.5% must be paid on the excess
reserves that banks hold with the central bank.
In "normal times" with interest rates of > 0%, the amount of CBDC below the
threshold would yield positive (or non-negative) interest. The interest rate on
15this "Tier 1 CBDC" is designed to follow the movements of all other market
rates but should be set, for example, 1% below the level of the deposit rate at
the central bank, thus making CBDC less attractive than bank deposits.
However, if the deposit rate fell below 1%, the Tier 1 CBDC interest rate would
remain at 0%, thus guaranteeing CBDC holders a non-negative interest rate
(see Figure 4).
Figure 4
Interest rates in the proposed two-tiered CBDC system
Source: Bindseil (2020).
The "excess" CBDC balances in the central bank account (“Tier 2 CBDC”)
would never be remunerated positively. If the ECB deposit rate falls below 1%,
the Tier 2 interest rate would become negative. In times of crisis, the spread
between the deposit rate and the Tier 2 rate could even be increased to avoid
bank runs. Such a two-tiered CBDC system would thus make a CBDC
unattractive as a store of value, as Tier 2 CBDC units would never bear a
positive interest rate.
16Lastly, a simple absolute limit of CBDC deposits per holder could be
introduced to prevent large liquidity outflows from the banking system into
the central bank balance sheet.
Anonymity concerns
In addition to threats for financial stability, the introduction of a CBDC could
also affect the privacy of sensitive transaction data. Today, payment methods
such as Apple Pay, bank transfers, or cash transactions differ in their level of
data privacy and anonymity. For example, if a transaction is made via Apple's
payment service Apple Pay, the transaction data can be seen and monitored
by Apple. If a bank transfer is used, payment details are available to the bank.
This does not hold for cash: cash is completely anonymous. With cash,
transactions are carried out on a peer-to-peer basis without any intermediary
that could potentially access transaction data. Thus, transaction details are
only available to the participating transaction partners. Such data privacy and
a certain degree of anonymity are also crucial for payments via CBDC.
In a paper published in December 2019 (ECB, 2019), the ECB presents and
discusses a concrete system for a cash-like retail CBDC in which (partially)
anonymous payments are enabled. This system is based on the distributed
ledger technology R3 Corda and is shown in Figure 5. The ECB’s sole
responsibility is to issue CBDC units. A network of banks takes over
administrative tasks, e.g., validation of the transactions, conducting anti-
money laundering (AML) checks, providing the necessary infrastructure, and
storing the cryptographic keys for initiating payments in clients’ digital
wallets.
Within this two-tiered system, (partially) anonymous payments are
guaranteed, which are compliant with AML regulations. A possible solution
for AML compliance would be that the identity and transaction history of the
sender would not be revealed to the central bank and an AML authority. In
the paper, the ECB addresses an essential trade-off between the possibility of
anonymous payments and the use of digital money for illegal activities. It is,
of course, desirable for the society that illegal activities such as terrorist
financing and money laundering are prevented. At the same time, however,
17from the citizens' perspective, it is desirable that anonymous payments, at
least to a certain extent, would be possible.5
Figure 5
Two-tiered CBDC system: Division of labor between the ECB and banks
Source: Andersch, Gross, and Schiller (2020).
Technically, this (partial) anonymity is ensured by not disclosing the identity
of the user to the central bank and the AML authority when so-called
anonymity vouchers are attached to the transaction. These vouchers allow
anonymous transfers of funds for a limited CBDC amount over a predefined
period of time. Every citizen is equipped with a certain number of anonymity
vouchers with which anonymous transactions can be carried out. As soon as
all vouchers have been redeemed, the transactions are no longer carried out
anonymously. One disadvantage of the model is that the transactions are
visible for the processing banks and, therefore, not completely anonymous.
In this respect, anonymity is only given between the transaction participants
and the central bank and AML authority. This is a clear disadvantage of the
prototype and should be considered in future prototypes and publications.6
18Nevertheless, this paper is a good starting point to further analyze anonymity
in retail CBDCs in connection with DLT.
Will there soon be a (central bank-issued) blockchain Euro?
Stablecoin projects have already tokenized Euros and other fiat currencies by
using DLT infrastructures. However, these tokens are currently mainly used
in crypto markets to “park” liquidity before investing in other crypto assets.
The Icelandic startup Monerium and the German startup Cash-on-Ledger are
the first startups that use an e-money license to conduct regulated
transactions in Icelandic krona, and Euro via the Ethereum blockchain and
therefore offer a blockchain-based Euro. Non-DLT-based synthetic CBDCs,
i.e., bank deposits or e-money 100% backed by central bank reserves, already
exist in China and El Salvador, where e-money licensed companies must hold
100% of the funds in central bank reserves.7 In addition, in recent years,
England and Lithuania, among others, have relaxed their e-money
regulations and now also allow e-money-licensed payment service providers
to access the central bank balance sheet and thus to back their deposits with
central bank reserves.
Current retail CBDC projects are shown in Figure 6. China is likely to be the
first developed economy to issue a retail CBDC. In April 2020, a test run of
the Chinese CBDC has been started in several cities where government
salaries were paid out in CBDC into the wallets of the public official. The
Swedish central bank (Riksbank) has been studying the issuance of a digital
version of the Swedish Krona (E-Krona) since 2017 to respond to the strong
decline in the usage of physical cash in the society. It is currently testing a
DLT-based E-Krona prototype (see Riksbank, 2020). In the Caribbean, the
Blockchain company Bitt has entered a partnership with the Eastern
Caribbean Central Bank. Both parties are jointly investigating the
applicability of DLT for an Eastern Caribbean Digital Dollar. A CBDC is
intended to increase financial inclusion for the inhabitants of the seven
Caribbean member islands by providing an easily accessible digital means of
payment. The Sand Dollar of the Bahamas pursues a similar goal and has
already been available to Bahamian citizens in a pilot phase since December
2019 (see Central Bank of Bahamas, 2020). The SOV, a crypto asset emitted
by the Central Bank of the Marshall Islands, is also expected to be issued in
the next few months.
19Figure 6
Overview of current retail CBDC projects
Source: Own depiction (Created via mapchart.net).
At the end of 2019, the ECB has intensified its CBDC efforts. Christine
Lagarde stressed at her first press conference as ECB President in November
2019 that the ECB will intensify efforts concerning CBDC and announced that
an internal CBDC Task Force will be established. Words were promptly
followed by deeds: The two ECB publications previously described show that
the ECB is now intensively researching a CBDC.
In addition, the ECB has joined a consortium of several central banks
including the Bank of England, the Bank of Japan, the Riksbank and the BIS
to share experiences from their analyses of potential use cases for CBDCs and
to jointly explore the implications of a CBDC introduction (see ECB, 2020b).
Thus, it seems possible that a CBDC could become reality in the Euro area in
a few years. Whether it will be based on the DLT remains to be seen.
20Manuel Klein is consultant at FactSet. Moreover, since 2015, he has been actively
engaged at the NGO Monetative for which he has been giving speeches about the
structure and problems of the current monetary system, cryptocurrencies and CBDC.
You can contact him via mail (manuel.klein@monetative.de) or via LinkedIn
(https://www.linkedin.com/in/manuel-klein/).
Jonas Gross is project manager at the Frankfurt School Blockchain Center and
Research Assistant at the University of Bayreuth. You can contact him via mail
(jonas.gross@fs-blockchain.de), via LinkedIn (https://www.linkedin.com
/in/jonasgross94/) or follow him on Twitter (@Jonas__Gross).
Prof. Dr. Philipp Sandner is head of the Frankfurt School Blockchain Center. You
can contact him via mail (email@philipp-sandner.de), via LinkedIn
(https://www.linkedin.com/in/philippsandner/) or follow him on Twitter
(@philippsandner).
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1 This article builds on and extends our German article Klein, Groß, Sandner (2020), which
has published in March 2020 in ifo Schnelldienst.
2 These include Tobin's Deposited Currency Accounts in Tobin (1987) and the Chicago Plan
in Fisher (1936).
3 On confidence in central banks, banks and other players in an economy, see OMFIF
(2020).
4 The report "Central Bank Digital Currencies" by IBM Blockchain World Wire and OMFIF
(2018) provides an overview of the results of the wholesale CBDC projects conducted to
date.
5 Crypto assets such as Monero, Dash or Zcash enable anonymous payments and are to be
regarded as an exception here.
6 A high degree of anonymity could be implemented, for example, in DLT systems using
zero knowledge proofs and ring signatures. For an overview of ways to implement
anonymity in DLT systems, see ECB, 2020a.
7 Alipay and Tencent must cover all deposits in central bank reserves (see Adrian, Mancini-
Griffoli, 2019).
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